Daripada gak ada postingan, akhirnya saya posting essay Option, Futures, and Risk Management mengenai krisis keuangan global tahun 2008 dan kaitannya dengan instrumen derivatives. Essay beginian jadi barang langka semasa kuliah di kampus tercinta ini. Dari 9 subject yang udah saya ambil, hanya ada dua tugas bikin essay, satu essay 1500 kata pas Business Communication, sama satu 10 halaman essay yang ini, sisa 7 subject laennya rata-rata bikin report dari tugas hitung-hitungan doang. Jadi patut dimaklumi kalo essay-nya acak adul gak karuan.
Kalo dipikir-pikir sih, ada hikmahnya juga ngerjain tugas essay yang ini karena kebetulan topiknya aktual banget, gonjang-ganjing krisis keuangan global. Minimal saya gak perlu malu-maluin, sebagai lulusan Applied Finance, kalo pas diajak ngobrol sama tukang ojek pas naek ojek, “emang apaan sih yang mbikin krisis global tahun 2008 itu?” Saya dengan gagahnya bisa jawab, ” tergantung siapa yang ngomong, Mas. Kalo kata Figlewski (2008)…..”
THE ROLE OF CREDIT DERIVATIVES
IN THE 2008 GLOBAL FINANCIAL CRISIS
The 2008 global financial crisis was referred to a continuing financial crisis, which happened globally from the mid-2007 to date. It was previously referred to ‘subprime mortgage crisis’, ‘credit squeeze’, ‘credit crises’, or ‘credit crunch’. However, in view of the fact that the scale of the crisis had spread globally, and since the crisis were clearly noticeable in September 2008 with the bankruptcy, merger, or bail-out of several largest financial institutions in United States, then the term ‘2008 global financial crisis’ is more suitably used. Henceforth, the 2008 global financial crisis will be termed ‘financial crisis’. Additionally, the magnitudes of the global financial crisis are so huge, so that Petrov proposes that the current financial crisis is much worse than the great depression in 1930’s.
In relation to the financial crisis, many analysts have proposed explanation and suggestion regarding the possible cause of the crisis. Each of the analysts has been focusing on the different part of the crisis, primarily because of the considerable size of crisis and the involvement of so many parts of the financial systems (Figlewski). Figlewski also suggests that a number of analysts have explored the enormous financial loss suffered by the US’s largest financial institution and its consequences to the future of financial institution in US and worldwide. Meanwhile, others were more focused on the severe effects caused by the financial crisis to the mortgage holders and property owners. In the meantime, other analysts were busy blaming the governments’ decisions to resolve the crisis. Finally, in center of the analysis, and blame, of the possible cause of the financial crisis are a great variety of complex and risky credit derivatives instrument created by financial institution around the world (Figlewski). Steverman refers this situation as a ‘financial crisis blame game.’
Therefore, this paper will analyze the role of credit derivatives in the financial crisis. Firstly, the subprime mortgage loan crisis as a trigger to the financial crisis will be explained. Further analysis of the credit derivatives role in the financial crisis and other possible cause of the financial crisis will then be discussed. The last section of this paper will conclude the credit derivatives’ role in the financial crisis.
B. The Subprime Mortgage Loan as a Trigger of the Financial Crisis
The possible causes of the current financial crisis are complex and intertwined each other. However, Mizen argues that the root cause of the financial crisis was the subprime mortgage crisis in United States. Subprime mortgage loan is defined as, “residential mortgages issued to high-risk borrowers, such as those with a history of late payments or bankruptcy” (Ishmael). It is also referred as ninja loan, which are the practice of lending mortgage loan to customers with ‘no job, no income, or no assets’ (Sheng). The amount of subprime loan in United States from 2001 to 2006 is described in Figure 1, as follow:
Subprime Mortgage Origination in United States
Source: Mizen (2008, p.537)
The graph shows that the amount of subprime mortgage loan has almost quadrupled from $160 billion in 2001 to $600 billion in 2006. The subprime mortgage loans were representing more than 20% of total annual mortgage origination (Mizen). The dramatic growth in subprime mortgage loan was made happen due to some reasons. Firstly, low long-term interest rates in the period of 2001 – 2004 as a result of the contractionary monetary policy by Federal Reserve of United States in order to prevent the further effect of dotcom bubbles burst and 9/11 tragedy, and combined with the with a stream of global saving from emerging market and oil-exporting countries (SELA). Secondly, the development of derivatives instrument created from mortgage loans, including subprime mortgage loans. These credit derivatives included the Mortgage-backed Securities (MBS), Collateralized Debt Obligations (CDOs), and Credit Default Swap (CDS). In order to maintain the volume of new mortgages for securitization, and further credit derivatives instruments, mortgage lenders have a tendency to expand their lending activity into previously unexploited market, such as subprime borrowers (SELA). Lastly, the real estate value had risen continuously and, consequently, had ensured mortgage lenders to keep giving out subprime mortgage loan. These combined conditions were contributing to the expansion of subprime mortgage loans without proper risk management.
Furthermore, the risks inherently built in the subprime mortgage loan are considered higher than other types of mortgage. Consequently, mortgage lenders were usually setting up higher up-front fee and higher interest rate for subprime borrowers in order to compensate these risks. On the other hand, subprime borrowers had relied heavily on market belief that the values of their properties will always rising, and always cover their mortgage loans’ value. In relation to this issue, investors of mortgage-related credit derivatives were also not fully concerned by the highly correlated link between the movement of real estate value and default risk of related mortgage loans. Investors were more focused on earning higher yields from ‘supposedly’ safe investment.
Afterwards, in 2006, the real estate value had dropped considerably. The decreasing value of real estate combined with the steadily increased of interest rate had made the mortgage borrower, most of it were subprime borrowers, were unable to pay their loan, i.e. they defaulted their mortgage loans. The percentage of default mortgage borrowers from the period of 1998 to 2008 is represented in Figure 2, as follow:
Residential Mortgage Default Rates in United States
Source: Mizen (2008, p. 540)
Graph 2 shows that the default rate of subprime mortgage borrowers have been constantly higher compared to other type of mortgage borrowers. Lately, the default rate of subprime mortgage borrowers has reached 18%. As a result, foreclosures are mainly involved subprime borrowers, more than 50% in 2008 (Mizen). Hence, subprime mortgage borrowers have created substantial loss in real estate industry in United States in the period of 2006 onwards.
On condition that the real estate industry was not intertwined with the financial system, the total loss in real estate industry will only be the drop in the real estate value (Figlewski). In fact, the loss arisen in the real economy from huge losses due to the burst of housing bubbles had been transferred through the financial system through the creation of complex credit derivatives (Figlewski).
C. The Role of Credit Derivatives Instruments in the 2008 Global Financial Crisis
Credit derivatives is defined as, “a derivative whose value derives from the credit risk on an underlying bond, loan or other financial asset (Ishmael). The creation of credit derivatives, to some extent, had affected the financial crisis. Since the huge loss suffered by the financial institution, such as Bear Stern, Lehman Brothers, AIG, etc., were caused by excessive derivatives transactions, most people were easily concluded that somehow the crisis are rooted from the credit derivatives (Figlewski). However, it is important to see how the derivatives instruments were created from the mortgage loans. The complexity and interrelatedness of the credit derivatives instruments, which were based from the mortgage loans, are described in Figure 3.
The Creation of Credit Derivatives Based on Mortgage Loans
It can be seen from Figure 3 that soon after the mortgage origination between the local bank and the homeowners, the mortgages were sold through the securitization process. This securitization combines the mortgage with other mortgages into a mortgage pool. This securitization resulted in a Mortgage-backed Securities (MBS) which then to be sold to financial market as Assets-backed Securities after being combined with credit cards loan, student loan, and auto loan (Figlewski). Furthermore, these Assets-backed Securities are then sliced, tranched, and then sold as Collateralized Debt Obligation (CDOs). CDOs are creatively constructed with different risk ratings to fulfill specific risk preferences of investors.
In addition, Credit-Default Swaps (CDS) were relatively new creation of financial derivatives instruments which also contributed to the severity of the crisis. CDS was developed in the mid-1990s in order to provide investors with the option to hedge and speculate the changing in credit spread. It was then created to insure the MBS so investors can swap their risk of default to the CDS holders (Meng & Gwilym). Besides, CDS are traded at out-of-the-counter and, consequently, have no formal clearing house and little, or no, public reporting regarding the pricing of the trades.
The complex derivatives system was initially designed to expand and provide a greater financial resource to the mortgages market. However, the expansions of mortgage loan were not followed by ensuring the performance of mortgage itself. The financial institution involved in mortgage loans, such as the initiator of the loan, the broker, the mortgage lender, and the bonds writer, were not concerning the performance of the mortgage. This situation was mainly caused by the structure of mortgage loan incentives that was correlated to the amount of mortgage transaction, not the quality of the mortgage (SELA). Turnbull, Crouhy, & Jarrow suggest that credit derivatives had encouraged the dramatic growth of credit supply to subprime mortgage borrowers.
Credit derivatives had also created complicated financial assets with relatively high yields and high credit ratings. Consequently, many financial institutions around the world such as banks, insurance companies, and pension funds, had invested in the credit derivatives instrument with an expectation of high profit and high credit ratings. Accordingly, the high risk of subprime mortgage loans had been transferred to the financial institution around the world by means of the credit derivatives. The involvement of financial institutions in mortgage based credit derivatives had also initiated another possible cause of the financial crisis, which is speculation.
Furthermore, Laing argues that derivatives instruments have become a ‘weapon of mass speculation’. He also further analyze that derivatives instruments has destabilized the international market for debt, and even equity. Meng & Gwilym explain further that credit derivatives instruments, especially CDS, had encouraged banks to take on riskier loans; helped increase leverage in the global financial system; and exposing a wider exposure to the risk of default. In fact, the bail out of AIG by the government of United States in September 2008 was largely due to their large exposure to the CDS (Eissinger).
Nevertheless, the use of derivatives will have little or no impact on real economy on condition that the underlying assets of credit derivatives, which are the mortgage loans, were remain solvent (Vactor). In contrast, the effect of credit derivatives on real economy could be intensified during the increasing volatility and combined with a quick and unexpected change in market.
Therefore, during the collapsed of real estate value and followed by increasing defaults from the subprime mortgage loans, the credit derivatives were also seriously affected as their value derived from their underlying assets. Due to the structure that was inherently built in the derivatives instrument, each default of the home loan were now multiplied many times, and no longer limited to the mortgage loans loan itself. Further mortgage default will have an effect on the higher credit derivatives interrelated with the mortgage. Credit derivatives instruments created to create profit in a booming market can suddenly change into a source of enormous loss.
Additionally, the practice of derivatives to leverage the financial position could amplify the profit, or loss. To illustrate, when a financial institutions has leveraged their derivatives instruments by 20:1 means that a 5% realized loss in underlying assets will transform into a 100% loss of their capital. As a result, a highly leveraged financial institution could lose all of its reserved capital even when default rates the subprime mortgage loans were low. In fact, failed financial companies, such as Lehman Brothers, Bear Stern, AIG, and others were far too leveraged to provide adequate capital to back their position.
Nevertheless, as hedges are never intended to take loss, derivatives are also created for reducing risk. Logically, if certain risks are removed from one party and shifted to another, the receiving party should prepare to support their position when market change. In reality, little had been done by involved financial institutions to cover their risks exposure.
Moreover, Eisinger argues that even though credit derivatives aren’t not solely responsible cause for the financial crisis, it has responsibly made the financial world more complex and opaque. He further suggests that the creation of credit derivatives was more responsible than anything else for intensifying the severity of the financial crisis. In addition, SELA also argues that the center of the crisis was the credit derivatives because the size and the complexity of instrument exchanged in it has increased the difficulty in assessing the level of exposure to subprime mortgage loans and determining the risks in each financial institution. Likewise, the uncertainty of the actual mortgage loss, since the actual loss itself has not been accurately calculated, has contributed to the further seriousness of the financial crisis (Figlewski).
Finally, the sum of the housing bubbles, foreclosure in subprime mortgage, poorly managed credit derivatives instruments, over-leveraged of derivatives instruments of many financial institutions, had made the financial crisis spread globally. Complex financial structure of derivatives instruments has also made the financial crisis become harder to be identified since it involved a systemic risk interrelated globally. In the end, the global financial system are too overloaded to suffer the loss.
In conclusion, the 2008 global financial crisis was triggered by the crisis in subprime mortgage loan in the United States. Initially, the combination of low interest rate, complex credit derivatives instruments, and excessive risks actions along with misleading incentive package by financial institutions had brought the expansion of the subprime mortgage loan. However, the slumping value of real estate combined with the steadily increased in interest rate had made many subprime mortgage borrowers defaulted their loan. The situation has created an enormous loss in real estate industry in United States.
Furthermore, the creation of complex credit derivatives instrument has extent the severity and coverage of the subprime mortgage loan crisis into a global financial crisis. The increasing default in the subprime mortgage loans as underlying assets of credit derivatives had brought considerable loss in credit derivatives instruments. Enormous loss in credit derivatives instruments transactions were mainly caused by inappropriate use of credit derivatives as speculation tools, poorly managed credit derivatives instrument, and over-leveraged exposure into the derivatives instruments. At last, global financial systems as a whole can no longer bore the loss, resulting in the 2008 global financial crisis.